Working Capital Management

Question 1

What is a firm’s working capital?

Answer 1

Working capital = current assets - current liabilities

Question 2

What does a working capital ratio say about a company?

Answer 2

It notes (a) the firm’s ability to pay off short-term debts (within one year) and (b) the firm’s ability to properly invest its assets

Thus, working capital could be too low, signaling that the firm is not sufficiently able to pay off debts – but it could also be too high, signaling that the firm hoards too much of its current assets when that could be making more money invested elsewhere

Question 3

What are the assets included in current assets (and thus in working capital)?

Answer 3

(i) cash
(ii) marketable securities
(iii) accounts receivable
(iv) inventory

Question 4

As regards cash, what are transaction balances and compensating balances?

Answer 4

Transaction balance = the total balance of cash due to routine collections and expenditures

Compensating balance = a minimum balance required by a bank below which fees will be charged on the account; this balance compensates the bank for their services, since it provides extra funds

Question 5

As regards cash, what are precautionary balances and speculative balances?

Answer 5

Precautionary balance = a balance maintained in case budgetary forecasts for cash are not met

Speculative balance = a balance held for unexpected deals that may show up in the future

Question 6

What are marketable securities?

Answer 6

Securities that are very liquid – i.e. that can be converted to cash very quickly and without much cost

Examples: Treasury bills, banker’s acceptances, commercial paper

Question 7

Why are marketable securities generally held?

Answer 7

They can serve as temporary investments (earning more than cash), or they can be held as a substitute for cash in emergencies

Question 8

What is one practice a firm can implement to reduce its transaction and precautionary balances?

Answer 8

Better align inflows and outflows of cash – properly timed, this will keep balances very low

Also can speed up collections and slow down payments (within legal and ethical boundaries) as needed

Question 9

As regards cash, what is float?

Answer 9

Discrepancies between accounts (usually a firm’s books and a bank account) arising due to the money being in transit

If there is delay on checks to others, then the account is higher than it would be, so it is a positive float
-likewise, if there is a delay on incoming checks, it is a negative float

Question 10

Firms have different times when they need more cash and other times when they need less; what are different strategies for dealing with this?

Answer 10

(1) investing in marketable securities and converting them to cash as needed has the benefits of avoiding debt and retaining a precautionary balance, but has the drawback of not maximizing returns on assets
(2) engaging in short-term debt when more cash is needed has the benefit of increasing returns on assets (since they’re not tied up in marketable securities), but has the drawbacks of paying interest and lacking any precautionary balances

A combination of the two can of course be utilized

Question 11

What are ordinary features of marketable securities?

Answer 11

Because they need to be converted into cash quickly, marketable securities are often (i) very liquid and (ii) safe (i.e. low risk)

Question 12

What is the Baumol-Tobin model?

Answer 12

A model made by William Baumol and James Tobin designed to show the optimal cash balance a firm should hold, balancing both (a) the liquidity that comes with holding cash and (b) the return or interest forgone in holding cash

This depends on the market interest rate, the fixed cost to convert cash to securities (or vice versa), and other factors

Question 13

What are different elements of a firm’s credit (A/R) policy?

Answer 13

(1) credit standards
(2) credit quality
(3) credit period
(4) early-payment discounts
(5) collection policy

Question 14

How do credit standards relate to a firm’s accounts receivable?

Answer 14

Definite credit standards help to show justifiable reasons why a firm can withhold credit from a potential customer (or reduce it) without breaking the law

Standards also save costs by avoiding default, costs to investigate particular customers (i.e. if there were no widely applicable standards), and costs for slow payment

Question 15

How does credit quality relate to a firm’s accounts receivable?

Answer 15

Various factors about a customer can help to determine the likelihood that he will default – these include the three C’s of credit:

(i) character: the ethical disposition of the customer to honor his debt
(ii) capacity: the customer’s ability to repay based on his income
(iii) capital: the customer’s ability to repay (or provide collateral) based on his assets, in case income is insufficient

Question 16

How does the credit period relate to a firm’s accounts receivable?

Answer 16

There is a trade-off in lengthening the time by which customers must pay their debt: lengthening the credit period increases sales but also increases the costs of A/Rs
-increases costs by increasing bad debt, slowing down payments, raising fixed transaction costs, and increasing the cost of carrying new receivables

Question 17

If a firm’s credit period is extended, how is the increased investment in receivables calculated?

Answer 17

(1) increased investment in earlier sales
+
(2) increased investment in new sales

(1) = change in avg. collection period x sales/day
(2) = variable cost/sales x new avg. collection period x incremental sales per day

Question 18

How do early-payment discounts relate to a firm’s accounts receivable?

Answer 18

Discounts for early payment of course help to reduce the collection period, but reduce total profits

Example: “3/5, n/30” means that 3% of the receivable will be discounted if paid within 5 days, and otherwise the net amount is due in 30 days

Question 19

How does a collection policy relate to a firm’s accounts receivable?

Answer 19

Collections on overdue accounts can sometimes hurt the company by straining relations (and thus hurting goodwill)

Collections also can be expensive in how much labor they require

Question 20

How do firms evaluate a change in credit policy?

Answer 20

Through incremental analysis – analyzing the additional sales and costs (and thus profits) caused by a given course of action

Question 21

What are the different areas affected by a change in credit policy?

Answer 21

(i) sales
(ii) production costs due to increased sales
(iii) bad debt expense
(iv) early-payment discounts
(v) cost of capital to finance A/Rs
(vi) labor costs for credit administration
(vii) collection expenses
(viii) interest income (not applicable to most A/Rs)

Question 22

What can a firm use to more clearly demarcate different A/Rs and thus keep better track of credit?

Answer 22

An aging schedule – keeping track of the outstanding duration for each receivable, especially since long-overdue A/Rs have a higher chance of nonpayment

Question 23

What are some attributes of successful inventory management?

Answer 23

(i) high turnover
(ii) minimal disposals of obsolete inventory
(iii) minimal gaps in work/assembly
(iv) minimal missed sales from inventory shortages

Question 24

What is the economic order quantity (EOQ)?

Answer 24

The optimal quantity of purchase orders (for inventory) that keeps order costs and carrying costs for inventory as low as possible

Question 25

What is the formula for the economic order quantity (EOQ)?

Answer 25

EOQ = sq. rt. √[(2 x order cost x annual demand) / (inv. carrying cost per unit)]

This gives the optimal quantity of inventory units that should be added to inventory (purchased) at one time

Question 26

Besides optimizing purchase orders, what else can the EOQ formula be used to calculate?

Answer 26

The optimal quantity in producing inventory (rather than purchasing it)

This would require the “order cost” in the formula to change to “setup cost” for manufacturing

Question 27

As regards inventory, what is the lead time?

Answer 27

The time lapse between the beginning of a process and its end – in this case between ordering inventory and receiving it

Question 28

As regards inventory, what is the reorder point?

Answer 28

The quantity at which more inventory needs to be ordered, given the time lag (lead time) between order and receipt

This will be the sum of any safety stock (i.e. kept for emergencies), if any, and the inventory for products demanded during the lead time

Question 29

As regards inventory, how does a firm calculate the inventory needed for products demanded during the lead time?

Answer 29

Avg. inv. needed per day to meet demand
x maximum lead time
= max inv. needed to meet demand

Alternatively, the avg. lead time could be used, or the minimum lead time – but the maximum would be the least risky

Question 30

When is short-term debt usually needed or utilized?

Answer 30

To meet seasonal needs and/or to finance current assets

Question 31

How do interest rates on short-term debt compare to rates on long-term debt?

Answer 31

Short-term interest rates are ordinarily lower

Question 32

How does risk vary for short-term debt and long-term debt?

Answer 32

Short-term debt is ordinarily riskier for the debtor than long-term debt:

• interest rates are more volatile
• lenders are less likely to extend loans if the debtor has trouble paying

Question 33

How is a firm’s liquidity to meet short-term debt usually measured?

Answer 33

With the quick ratio/acid test ratio

(Cash + marketable securities + A/R) / (current liabilities)

OR: (current assets - inventory) / (current liabilities)

Question 34

What is the main management consideration for accounts payable?

Answer 34

Ensuring correct decisions for early-payment discounts

Question 35

Is the credit received for accounts payable free?

Answer 35

Strictly speaking, no, since the other company has various costs from extending credit for its receivables (the time value of money, administration costs, etc.) which are then passed on to customers despite their extended credit

Practically speaking, yes, since the company offering the credit usually doesn’t offer anything better for cash payments

Question 36

Given that credit for A/Ps is practically free, what is the main management decision to be made?

Answer 36

Whether the discount for early payment should be accepted, or whether the company could gain more by investing the money and paying the full payable at the very end of the credit period

Question 37

What is a practice firms could do to gain more from the credit of their A/Ps?

Answer 37

Stretch the terms of the contract – e.g. send a discounted payment after the discount date, or send the whole payment after the credit period

This will sometimes go unopposed (particularly if the other firm is tight financially and doesn’t want to lose a customer), but it lowers goodwill and could disincline the other company from help it might otherwise provide in the future

Question 38

How does a firm mathematically decide whether to take the early-payment discount or not?

Answer 38

(1) the amount of extra credit gained by forgoing the discount should be calculated by taking the change in the daily avg. for A/P and multiplying that by the number of days credit is extended
(2) the amount of discount should be calculated (a simple % calculation)

If the early discount were selected, then (1) would be the opportunity cost of that selection, so the firm would have to get a greater return on investment from the extra credit (i.e. greater than (2) / (1)) in order to justify forgoing the credit

Question 39

What is an example of a firm deciding whether to take an early-payment discount?

Answer 39

A firm has A/P of $73,000 to a merchant with terms 1/10, n/30

(1) change in daily avg. for A/P –> $73,000 / 365 days x (30 days - 10 days) = $4,000
- thus $4,000 is the extra credit gained by forgoing the discount
(2) discount = 1% x $73,000 = $730

The extra credit of $4,000 would have to generate more than $730 in order to be worth forgoing the discount, and thus the extra credit would have to generate a return beyond 18.25% ($730 / $4,000) for the decision to be rational

Question 40

What are notes payable?

Answer 40

Short-term loans (often 90 days) firms take out with banks

Made with a promissory note, which is the contract specifying the loan conditions

Question 41

How do compensating balances relate to notes payable?

Answer 41

Sometimes banks require borrowers to have a specific amount of the lent money held as a compensating balance in a checking account – this requires that much more cash to be borrowed, thus increasing the effective rate of interest

Question 42

How do compensating balances increase the effective rate of interest for notes payable?

Answer 42

Since a compensating balance requirement would mean that the firm must borrow more money from the bank, the firm has to pay interest on that amount too, even though it’s required to hold that money with the bank – thus the interest rate paid on the real loan (the amount not held in the checking account) is effectively higher

Question 43

What is a line of credit?

Answer 43

When a bank (or other financial institution) establishes a maximum borrowing amount which the customer can borrow from at any time

Besides interest on the borrowed amount, this sometimes involves a “commitment fee” to be paid on the unused credit

Question 44

What is commercial paper?

Answer 44

An unsecured promissory note with a maturity under 270 days

The 270-day limit is to avoid the need of registering the paper with the SEC, thus reducing costs (and for the same reason it is often made to “sophisticated investors,” like mutual funds)

Question 45

Who normally issues commercial paper?

Answer 45

Corporations with a healthy financial condition and good credit rating – otherwise the risk can be too much (or force the interest rates to be too high)

Question 46

What are derivatives?

Answer 46

Financial contracts whose value is derived from an underlying asset

Ordinarily used to manage risk

Question 47

What are forward contracts?

Answer 47

A type of derivative where the two parties agree to transact some asset on some future date at a price fixed in the present

A common type of forward contract exchanges foreign currency

Question 48

What are futures contracts?

Answer 48

Similar to forward contracts except that these always take place on regulated exchanges, rather than as private transactions

Question 49

How do futures contracts reduce the counterparty risk as compared to forward contracts?

Answer 49

Forward contracts, being made between private individuals, have a much higher risk that one party will default (counterparty risk)

Futures contracts, taking place on regulated exchanges, have a clearinghouse essentially act as the counterparty and thus reduce that risk, e.g. by having margin requirements for investors

Question 50

How does “marking to market” relate to the decreased counterparty risk of futures contracts?

Answer 50

While forward contracts generally have one transfer of money take place during the contract, futures contracts require the difference between the originally-agreed-upon price and the daily futures price to be settled every day – thus money is transferred every day as the value of the contract is “marked to market”

Think of this as the fact that futures contracts require unrealized gains or losses on the changing futures rates to be realized every day

Question 51

What is an interest rate swap?

Answer 51

Derivatives where two firms decide to exchange interest payments on each other’s loans

They do not exchange the principal, but they calculate the interest based on a “notional” amount, which is a hypothetical principal for which they are paying interest to the other firm

Question 52

How does an interest rate swap work?

Answer 52

It usually requires one firm who wants a variable rate of interest and another who wants a fixed rate, and they also have different credit ratings

Each gets the opposite type of interest rate from their bank and then exchanges different interest rates with each other in such a way that they both gain

Question 53

What is an example of an interest rate swap?

Answer 53

Co. X (who has a better credit rating) wants a variable rate while Co. Y wants a fixed rate – both their desired loans have the same principal

• X’s bank offers X either a 7% fixed rate or a variable rate equal to LIBOR
• Y’s bank offers Y either a 10% fixed rate or a variable rate equal to LIBOR + 1%

X selects its offered fixed rate (7%), while Y selects its offered variable rate (LIBOR + 1%)
-X and Y agree to swap interest rates: X will pay Y interest equal to LIBOR on the notional principal, while Y will pay X 8% interest

X receives 8% from Y, and pays 7% to its bank and LIBOR to Y – so X pays a total of LIBOR - 1% interest

• Y receives LIBOR from X, and pays LIBOR + 1% to its bank and 8% to X – so Y pays a total of 9%
• Thus both X and Y pay their desired type of rate (variable/fixed), and both pay less than what their banks offered

Question 54

What is LIBOR?

Answer 54

London Interbank Offered Rate – calculated by primary banks in London to estimate the interest rate they would be charged if they borrowed from other banks

Most common benchmark for measuring short-term interest rates

Question 55

Why does an interest rate swap work?

Answer 55

Imagine if two banks (one desiring fixed interest, the other variable) switched the exact interest rates they got from their bank – in such a case, the bank with the superior credit rating would lose a certain amount of interest and the bank with the inferior credit rating would gain a certain amount of interest

The point of a swap is that, if the gain on the above exchange is greater than the loss, then this net gain can be distributed between both banks in a swap so that it is mutually beneficial

Question 56

What is an example showing why interest rate swaps work?

Answer 56

Co. X (who has a better credit rating) wants a variable rate while Co. Y wants a fixed rate – both their desired loans have the same principal

• X’s bank offers X either a 7% fixed rate or a variable rate equal to LIBOR
• Y’s bank offers Y either a 10% fixed rate or a variable rate equal to LIBOR + 1%

If X were to take Y’s variable rate (LIBOR + 1%), it would assume a rate 1% higher than the variable rate it could get from X’s bank (LIBOR)

• If Y were to take X’s fixed rate (7%), it would assume a rate 3% lower than the fixed rate it could get from Y’s bank (10%)
• Thus if they simply exchanged the exact rates they accepted, X would pay 1% more in interest and Y would pay 3% less

This net gain of 2% can be distributed between X and Y based on the terms of the swap – both would have to gain from it for parties to be willing to do it
-If there were no net gain, then no interest rate swap could be mutually profitable

Question 57

What is an option contract?

Answer 57

A derivative contract involving a contract to buy or sell some underlying asset at a point in the future

Call option = right to buy
Put option = right to sell